Perspectives

Roth IRAs Offer Teenagers a Head Start on Retirement Saving

Parents (or grandparents) who want to give their teenagers with part-time jobs a huge head start on saving for retirement should encourage them to open a Roth IRA. Many financial institutions, including T. Rowe Price, allow Roth IRAs to be set up for minors with the assistance of a parent or guard-ian. For the 2011 and 2012 tax years, a child can invest earnings up to $5,000 in a Roth IRA.

Unlike Traditional IRAs, contributions to Roth IRAs are not tax-deductible, but potential  earnings are tax-free if withdrawn after age 59½ (and the account has been established at least five years). These tax advantages, along with the power of compounding, offer teenagers with earned income substantial growth potential. For example, if a child earns and invests $2,000 a year from age 13 to 17, that $10,000 total investment would grow to a tax-free nest egg of almost $296,000 (in future dollars) by age 65, assuming a 7% annual return. That would provide tax-free income of more than $11,800 a year for 30 years (or $2,545 a year in today’s purchas-ing power, assuming 3% inflation).

“By encouraging working children to invest in a Roth IRA, parents can teach their children the benefits of saving early and compound growth, and might even give them incen-tive to earn more,” says Christine Fahlund, a senior financial planner at T. Rowe Price. “Starting early gives their children a big head start on saving for retirement.” Ms. Fahlund also suggests that the parents (or grandparents) could con-sider making a gift to their children to help with their savings plans.

Other Options

Of course, it may be unrealistic to expect young adults to envision their own retirement, which won’t begin until many decades in the future. But Roth IRAs can be tapped for other purposes as well. Generally, all contributions (i.e., principal) to the Roth IRA can be withdrawn tax-free at any time with no penalty. Earnings are considered withdrawn after the contributions and are typically taxable, along with a 10% penalty if withdrawn from the account prior to age 59½. However, the 10% early withdrawal penalty on earnings taken before age 59½ is waived if used for qualified college expenses or for a first-time home purchase (up to $10,000). Judith Ward, a T. Rowe Price senior financial planner, also notes that assets in a Roth IRA would not likely affect a child’s eligibility for federal financial aid. Only some private universities consider these assets in evaluating eligibility for tuition assistance. “Parents might check now with the institutions their teenager might be interested in to determine whether or not the savings in a Roth IRA would be considered in any aid formula by the school,” Ms. Ward suggests. “Given the low tax bracket that most teenagers are in, and the length of time they have to invest, a Roth IRA is likely to provide the most long-term after-tax benefit, especially if they hold off tapping the account until they retire,” Ms. Ward says.

One word of caution: Once a child reaches the age of majority, the assets are controlled by the child and could be withdrawn for any purpose.